Private money – the rules of physics may not apply

Friday, June 3rd, 2016 at 12:49 pm

Clay Sparkman

I first posted this article in August of 2009. That was right about when I was just getting started with the blog. It is hard to believe that it has been nearly seven years now. At any rate, I feel that this article deserves a second look (or a first look, if you are a more recent subscriber and haven’t been combing the archives). So here you go. Enjoy!

I would like to make a proposal. I would like to propose that the standard universal laws don’t necessarily apply to private money lending. That is, the things which we most take for granted—or assume to be true–may not be true in the realm of private money lending.

Let’s talk about systems for a moment. Let’s take physics as an example. Physics is the scientific mechanism which man has devised for describing, conceptualizing and predicting the behavior of the physical world. In the realm of physics, if one rule or one aspect of the system is called into question—even a small matter—then the entire system must be called into question. This has happened on various occasions as the science of physics has evolved, and as you can well imagine, it has caused quite a fuss among those who study physics.

My goal here is to break your notion that the things which you “know to be true” in the realm of private money lending can be correctly assumed to be true all the time. Let’s start with something absolutely fundamental. Everyone agrees that there is a direct relationship between the perceived risk of loss of investment capital associated with a particular investment and the rate of return from that investment. And I think it would be fair to say that pretty much everyone in the field agrees (1) that private money loans are riskier than their institutional counterparts (hereinafter referred to as institutional loans, a category to include conventional loans, sub-prime loans, and everything not included in the category of private money) and thus carry higher interest rates, and (2) that within the private money realm, riskier loans carry higher interest rates than those which are perceived to be less risky. I would be quite surprised if any of my readers take issue with either of these two basic notions. Let me clarify one more time because this is important: when I speak of risk here, I am referring to the risk of direct monetary loss of investment capital.

So let me now proceed to turn these two basic notions upside down. Fundamental notion #1 suggests that private money loans are riskier than institutional loans and that this is the reason why they carry higher interest rates. This is quite simply wrong. Institutional lenders don’t avoid risky loans per say. In fact, the sub-prime realm tends to thrive on them. Institutional lenders can (and do) factor known risk into their lending process. What institutional lenders will not tolerate is this: they will not tolerate loans which cannot be analyzed or characterized within a specific manageable and objective framework. Put another way, institutional lenders are only interested in commodity loans—as opposed, let’s say, to custom loans.

And why is this true? It is true because institutional lenders choose to manage risk as objectively as possible, and this can only be done effectively within a commodity-based loan system. Even though these lenders can accommodate almost any degree of risk, they prefer to factor out (wherever possible) risk which is anticipated buy not measurable. Using FICO scores and other specific measures, the typical institutional lender can predict to within a dime the value of their loan portfolios that will go bad (with the primary exception being vast rapid swings in the greater economy; there are many indicators, but ultimately these can only be guessed at). Any given loan involves a certain amount of risk, but the risk associated with a portfolio of commodity loans is considered measurable.

In case you’re not buying this particular line of logic, and you think that I’m just working with smoke and mirrors here, let me offer some (fairly) objective data. At Fairfield Financial, we manage a portfolio of 200+ private money loans at any given time, a package that adds up to about $30 million dollars in face value. Our average mid-score for that package is between 650 and 660. That portfolio sees an average of 2 loans per year go to REO. That is a 1% foreclosure rate. Those are good figures: 650-660 mid scores and 1% foreclosure rate. I suspect that many institutional lenders would rather enjoy such numbers. And thus, it seems that our loans are not necessarily more risky—or even as risky—as their institutional counterpart. Then of course our rates must be on par with the institutional realm as well, yes? No. Our median interest rate is 13% (fixed).

Okay fine. Certain irregularities occur in the risk-reward relationship when crossing from the institutional money realm to the realm of private money. But surely we can say—with complete confidence–that within the realm of private money, riskier loans carry a higher rate of interest than those perceived to be less risky. Here again, I would respectively suggest: it just aint so!

Private money lenders are averse to risk–as are all investors. However, private money lenders on the whole are particularly averse to risk of default (as opposed to risk of loss). Risk of default involves (a) temporary cash flow interruptions (something we affectionately refer to as “cashflowus interuptus”), (b) lying awake at nights and worrying about non-performing or sporadically-performing loans (which we call “bad boys”), and (c) lots of hassles and many hours of work (which tend to accompany the bad boys).

In fact, I would assert that on the whole private money lenders are less averse to risk of long-term potential loss then they are to risk of default, which we shall refer to hereafter as the “bad boy problems.” I have spent the past 15 years of my life pricing private money loans and have a pretty good idea of how the market works. Pricing private money loans is a little like pricing antiques but tougher; it is a highly subjective process. But of course there are certain guidelines. One takes a hard look at the long-term risk of the loan and at the potential for bad boy problems. I would argue that the best indicator of long-term risk is LTV. Bad boy problem indicators (such as credit, income, and pay history) may play into the risk equation, but as any private money lender will tell you, they are betting on the equity first and the borrower second—and in fact the borrower is a distant second. Having established LTV as a risk indicator, let’s look for a bad boy indicator. Let’s go with FICO mid-score. I have found that FICO mid-score is indeed a very reliable indicator of the likelihood that you will have a bad boy on your hands. When it comes to financial responsibility/performance, it seems that the past is a very good predictor of the future.

So now we have two objective scales to work with: LTV and FICO mid-score. Here I’m going to take a giant leap (very unscientific, but also very interesting) and make the assumption that these two scales are basically linear. The LTV scale for private money loans basically runs from 0% to 75%. The FICO mid-score scale runs from 300 to 850. So that now we have established a ratio of 7.33 between the two scales ([850-300]/75). Thus we can say that a 10% change in LTV on the risk scale is roughly proportionate to a change of 73 in FICO mid-score on the bad boy scale.

If risk is the primary factor driving interest rate, then a 75% LTV loan to a borrower with a 700 mid-score would carry a higher interest rate than a 55% LTV loan to a borrower with a 554 mid-score. Well, in fact just the opposite happens. Equalizing for other factors, I would tend to price the first loan at 12-13% and the second loan at 14-15%. So you see, long-term risk is a distant second to bad boy factors when pricing a private money loan.

Someone I respect immensely recently said that it is not what we don’t know that endangers us the most. It is what we think we know but know incorrectly.

If you go away from this post knowing that the risk-reward relationship as applied to private money is a myth, then you have learned a little something. If you lie awake tonight and wonder if things that go up in the private money universe really must come down—then that, dare I say, may qualify as an epiphany.

Clay

- Clay (clay@privatemoneysource.com, 503-476-2909)

Clay is Vice President of Fairfield Financial, a primary source for private money loans since 1964. Fairfield works with a broad range of private money investors, in a broker capacity, finding, underwriting, presenting, closing, servicing, and when necessary, assisting in the workout of difficult loans.

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This blog deals with all aspects of investing in private money loans and hard money loans secured by trust deeds and real property, including underwriting, risk assessment, loan servicing, and workout/recovery.

Bio

I am Vice President of Fairfield Financial, and I have been coordinating private money loan transactions since 1992. I hold an MBA degree from Portland State University and a BS in Economics and Computer Science from the University of Oregon. I have two active blogs: The Private Money Investor and The Private Money Broker.